The scandal-ridden program that allows industry to provide oil and natural gas directly to the Interior Department in lieu of cash royalty payments will be killed, Interior Secretary Ken Salazar said today.

"The royalty-in-kind program has been a blemish, in my view, on this department," Salazar said at a House Natural Resources Committee hearing. "There were allegations of sex and drugs and a whole host of other inappropriate conduct. ... My decision is that it's time for us to end the royalty-in-kind program."

Because the program was created through an administrative action, Salazar said he has the authority to cancel it.

The secretary added that the program was set up at a time when it was thought Interior could make more money by taking product -- which Interior then sells -- instead of money from oil and gas producers. But he noted that the department does not have a similar program for its timber or grazing assets.

Natural Resources Chairman Nick Rahall (D-W.Va.) has introduced a sweeping bill, H.R. 3534 (pdf), that would overhaul the federal royalty system and make other broad changes to Interior's regulation of oil and gas drilling on federal lands and waters. Rahall's bill would also eliminate the royalty-in-kind program.

"Bravo, bravo, bravo," Rahall told Salazar after the announcement. "I do think it will end the opportunity for mischief, or the temptation, and perhaps provide a more decent return for the American taxpayer, so I salute you for that."

A report by the Interior inspector general last year found that 19 employees, nearly one-third of the entire staff of the royalty-in-kind program, socialized with and received a wide array of gifts and gratuities from oil and gas companies with which the agency was conducting official business (E&ENews PM, Sept. 10, 2008). Rahall said the employees "put partying and cozying up with industry officials above getting a fair return for the American taxpayer."

Also, several other outside reviews have found a suite of oversight and enforcement troubles with the program. Federal oil and gas royalties are one of the government's largest sources of non-tax revenue.

Most recently, a Government Accountability Office report made public this week found that inadequate Interior tracking and verification of natural gas royalties paid in kind are leading to forgone federal revenue (E&ENews PM, Sept. 14). The report cited a host of problems with monitoring and data collection.

Oil industry calls Salazar plan a mistake

Salazar's decision drew quick criticism from the American Petroleum Institute, the oil industry's biggest trade group, which argued that it remains a simpler system than calculating cash royalties owed.

"Terminating this straightforward method of handling royalty payments runs the risk of raising administrative costs and adding additional layers of paperwork required to determine the value of oil and gas production," said API President Jack Gerard.

Interior's Minerals Management Service has similarly argued in the past that the program can simplify royalty collections, lowering administrative costs and avoid conflicts with energy companies over the value of oil and gas produced.

The Project on Government Oversight, a watchdog group that has criticized Interior's royalties oversight, cheered the decision, alleging the program has been a failure.

"Secretary Salazar's testimony today is a big step to finally ending this gift to industry, and POGO congratulates him for taking this stand. The next important step is ensuring Congress puts the final nail in the RIK coffin so it doesn't rise again," Executive Director Danielle Brian said in a statement.

The program began in earnest in the late 1990s with several pilot programs and grew substantially. Of the more than $12 billion in royalties that MMS collected in fiscal 2008, more than half came from the royalty-in-kind program rather than cash payments by producers, according to GAO.

While Rahall cheered the program's demise, his Senate counterpart -- Energy and Natural Resources Chairman Jeff Bingaman (D-N.M.) -- said he wanted to learn more about the decision. "We need to get a briefing from the department that led to this conclusion," he said. "It may be the right decision. I haven't seen the justification. We will be looking into that."

Salazar said he will issue a secretarial order in the next few weeks to end the royalty-in-kind program. The phasing out of the program will take at least a year, because there are contracts in place that must be honored, he added.

The restructuring will be overseen by Wilma Lewis, Interior's assistant secretary for land and minerals management, and the directors of MMS and the Bureau of Land Management.

More changes to come?

Salazar today emphasized that ending the royalty-in-kind program is "only one thing" among many the department needs to tackle, including royalty simplification and creating a new organization and management structure for the federal agencies that oversee energy development on public lands.

Rahall's bill would forge a new Interior agency to govern oil and gas leasing on federal lands and overhaul the federal royalty system.

The measure also includes provisions to improve planning for offshore energy development, address wind and solar programs, and boost funding for ocean conservation and land acquisition. It comes largely as a response to a series of scandals and scathing government watchdog reports on the federal agencies that handle oil and gas drilling on public lands.

Salazar said the administration has not had an opportunity to fully analyze the legislation but is in agreement with its primary goals of ensuring a balanced approach to energy development on public lands and dependable oversight of the mineral royalty programs.

Salazar said Rahall's bill is "absolutely targeted on the right set of issues," especially those raised by the government watchdog agencies. He added that Interior officials will continue working with the committee "to get the bill to a place where we believe it needs to get. ... We do have some ideas we will continue to contribute to try to make the bill a better bill."

He said Interior is developing options to improve coordination with MMS and BLM in leasing and revenue management but stopped short of endorsing Rahall's proposal to consolidate the two agencies.

The legislation would create the "Office of Federal Energy and Minerals Leasing" to handle onshore and offshore lease sales, inspection, enforcement and revenue collection. It would consolidate the oil and gas, wind, wave and solar programs now carried out by BLM and MMS. The Interior inspector general would take over the current functions of the MMS audit and compliance management section.

"Having one agency do the leasing and one agency collect the money is inefficient, unnecessarily complex and potentially costs the American people millions in lost royalties," Rahall said.

As for the proposed merger of the BLM and MMS, Salazar agreed that there should be an office of energy within Interior that coordinates between the agencies. But he added that how that will be structured or carried out remains to be seen.

Salazar also called for raising onshore royalty rates. He noted that the Bush administration raised offshore rates but that the onshore royalty had not been increased in a long while. He said he'd consider a variable rate that would take into account the amount of risk that companies need to undertake while exploring.

Natural Resources Committee ranking member Doc Hastings (R-Wash.) objected to the proposed consolidation, saying that the legislation would simply create new problems.

"This legislation creates a new bureaucracy, it raises the costs of producing energy with higher and new fees, and it potentially adds years of delay to energy development both offshore and on federal lands," Hastings said.